Hewlett-Packard Increases Dividend by 10%

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Mar 19, 2015
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In this article, let's take a look at Hewlett-Packard Company (HPQ, Financial), a $60.03 billion market cap company, which provides products, technologies, software, solutions, and services to a wide range of consumers.

Dividend Hike

The firm has an attractive dividend policy showing its commitment to return cash to investors in the form of dividends as it generates healthy cash flow on a regular basis.

It has announced a 10% increase in its quarterly dividend from 16 to 17.6 cents per share, which will generate an annualized dividend of $0.6 cents per share.

The dividend yield was 1.94%, and with a closing price of $33.03 this make an annualized dividend yield of 2.13%, greater than Apple’s (APPL, Financial) 1.5% yield and Oracle’s (ORCL, Financial) 1.1%, but below 2.9% paid by IBM (IBM, Financial) or the 3.1% paid by Intel (INTC, Financial).

Valuation

In stock valuation models, dividend discount models (DDM) define cash flow as the dividends to be received by the shareholders. Extending the period indefinitely, the fundamental value of the stock is the present value of an infinite stream of dividends.

Although this is theoretically correct, it requires forecasting dividends for many periods, so we can use some growth models like: Gordon (constant) growth model, the Two or Three stage growth model or the H-Model (which is a special case of a two-stage model).With the appropriate model, we can forecast dividends up to the end of the investment horizon where we no longer have confidence in the forecasts and then forecast a terminal value based on some other method, such as a multiple of book value or earnings.

To start with, the Gordon Growth Model (GGM) assumes that dividends increase at a constant rate indefinitely.

This formula condenses to: V0=(D0 (1+g))/(r-g)=D1/(r-g)

where:

V0 = fundamental value

D0 = last year dividends per share of Exxon's common stock

r = required rate of return on the common stock

g = dividend growth rate

Let´s estimate the inputs for modeling:

Required Rate of Return (r)

The capital asset pricing model (CAPM) estimates the required return on equity using the following formula: required return on stockj = risk-free rate + beta of j x equity risk premium

Assumptions:

Risk-Free Rate: Rate of return on LT Government Debt: RF = 2.67%. This is a very low rate because of today´s context. Since 1900, yields have ranged from a little less than 2% to 15%; with an average rate of 4.9%. So I think it is more appropriate to use this rate.

Beta: β =1.34

GGM equity risk premium = (1-year forecasted dividend yield on market index) +(consensus long-term earnings growth rate) – (long-term government bond yield) = 2.13% + 11.97% - 2.67% = 11.43%[1]

rHPQ = RF + βHPQ [GGM ERP]

= 4.9% + 1.34 [11.43%]

= 20.22%

Dividend growth rate (g)

The sustainable growth rate is the rate at which earnings and dividends can grow indefinitely assuming that the firm´s debt-to-equity ratio is unchanged and it doesn´t issue new equity.

g = b x ROE

b = retention rate

ROE=(Net Income)/Equity= ((Net Income)/Sales).(Sales/(Total Assets)).((Total Assets)/Equity)

The “PRAT” Model:

g= ((Net Income-Dividends)/(Net Income)).((Net Income)/Sales).(Sales/(Total Assets)).((Total Assets)/Equity)

Let´s collect the information we need to get the dividend growth rate:

Financial Data (USD $ in millions) Oct 31, 2014 Oct 31, 2013 Oct 31, 2012
Cash dividends declared 1.184.000 1.105.000 1.015.000
Net income applicable to common shares 5.013.000 5.113.000 12.650.000
Net sales 111.454.000 112.298.000 120.357.000
Total assets 103.206.000 105.676.000 108.768.000
Total Shareholders' equity 26.731.000 27.269.000 22.436.000
Ratios   Â
Retention rate 1 0,78 0,92
Profit margin 0,04 0,05 0,11
Asset turnover 1,08 1,06 1,11
Financial leverage 3,82 4,25 3,56
   Â
Retention rate = (Net Income – Cash dividends declared) ÷ Net Income = 0,76
   Â
Profit margin = Net Income ÷ Net sales = 0,04 Â Â
   Â
Asset turnover = Net sales ÷ Total assets = 1,08 Â Â
   Â
Financial leverage = Total assets ÷ Total Shareholders' equity = 3,86 Â
   Â
Averages   Â
Retention rate 0,82 Â Â
Profit margin 0,07 Â Â
Asset turnover 1,08 Â Â
Financial leverage 3,88 Â Â
   Â
g = Retention rate × Profit margin × Asset turnover × Financial leverage Â
   Â
Dividend growth rate 22,53% Â Â
   Â

Because for most companies, the GGM is unrealistic, let´s consider the H-Model which assumes a growth rate that starts high and then declines linearly over the high growth stage, until it reverts to the long-run rate. A smoother transition to the mature phase growth rate that is more realistic.

Dividend growth rate (g) implied by Gordon growth model (long-run rate)

With the GGM formula and simple math:

g = (P0.r - D0)/(P0+D0)

= ($33.03 ×20.22% – $0.704) ÷ ($33.03 + $0.704) = 17.71%.

The growth rates are:

Year Value g(t)
1 g(1) 22,53%
2 g(2) 21,32%
3 g(3) 20,12%
4 g(4) 18,91%
5 g(5) 17,71%

G(2), g(3) and g(4) are calculated using linear interpolation between g(1) and g(5).

Calculation of Intrinsic Value

Year Value Cash Flow Present value
0 Div 0 0,70 Â
1 Div 1 0,86 0,72
2 Div 2 1,05 0,72
3 Div 3 1,26 0,72
4 Div 4 1,49 0,72
5 Div 5 1,76 0,70
5 Terminal Value 82,56 32,88
Intrinsic value   36,46
Current share price   33,03

Final Comment

We have covered just one valuation method and investors should not be relied on alone in order to determine a fair (over/under) value for a potential investment.

The price is below the intrinsic value, so we can say that the stock is undervalued, and so, in my opinion subject to a potential buy. Further, considering that the stock is down by 17% in the last three months, I think there is an upside potential for this stock to resurge.

Hedge funds guru Steven Cohen (Trades, Portfolio) bought 626,900 shares while Joel Greenblatt (Trades, Portfolio), Jim Simons (Trades, Portfolio), Ken Fisher (Trades, Portfolio), Jean-Marie Eveillard (Trades, Portfolio) and Charles de Vaulx (Trades, Portfolio) have taken long positions in the stock, as well as PRIMECAP Management (Trades, Portfolio) in the fourth quarter of 2014.

Disclosure: Omar Venerio holds no position in any stocks mentioned.


[1] This values where obtained from Blommberg´s CRP function.